What Is a Synthetic Collateralized Debt Obligation?

A synthetic collateralized debt obligation is a derivative financial instrument that allows investment in credit default swaps and other non-cash assets with the goal of being exposed to fixed income assets. Whereas a credit default swap is a single security with a very high risk, a synthetic collateralized debt obligation involves a portfolio of these securities. The instrument may be divided into tranches with different levels of risk, enabling investors to choose the degree of risk to which they are willing to be exposed. The synthetic collateralized debt obligation, therefore, enables investors to obtain exposure to the income stream from those underlying fixed income assets while taking on an acceptable level of risk.

A synthetic collateralized debt obligation would not normally be traded on a stock exchange. Financial intermediaries such as investment banks and hedge funds may become involved in the selection of reference securities such as credit derivatives and selecting the counterparties. Some synthetic collateralized debt obligations have just a single tranche. If there are a number of tranches, then the investors holding lower tranches will make an initial payment; higher tranches, which are riskier, don't always require that initial payment. The equity, or mezzanine, tranches tend to contain a smaller part of the notional amount of the reference portfolio, but they also are likely to bear the majority of the credit risk.

Income flowing from the underlying assets is passed on to investors in the form of periodic payments. The use of credit default swaps or other credit derivatives helps ensure that investors receive a high return, but there also is a high level of risk involved. The underlying assets relating to these credit default swaps may have a high default rate. If a number of negative credit events — such as bankruptcy or failure to pay — happen, then the investors may be liable for losses much higher than their initial investments.

The advantages of a synthetic collateralized debt obligation to investors include the flexibility for investors to take on higher or lower risk corresponding to the different tranches. The period of time for which the synthetic collateralized debt obligation is held may be fairly short, and this may be an advantage for some investors. Businesses holding large numbers of commercial loans may hedge their position by using synthetic collateralized debt obligations, while these instruments may also be used by speculators to achieve high income with corresponding risk.